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Income per capita is how much money each person earns in average in a particular time. It is used to indicate the economy for an area and to evaluate the living standards and the quality of life for different countries, nations or regions. It is usually measured by dividing the national income of a country, which is the entire income of all the people arising from a country’s gross domestic product (GDP), by the entire population of the country.

Income per capita= total personal income of a country/ the entire population of the country

For example, let’s suppose there is a city where 1,000 people are making $200 per year and 100 people earning $1 million per year so the income per capita is ($200x1000people)+($1 million x 100people) / 1100 = $91,091.

b) The weakness of relying on ‘income per capita’

Income per capita is a very useful tool to assess the wealth of a nation, especially when comparing to other nations. By using income per capita, we can compare the economic well being of an individual in the country or the living standards between countries or the living standards within country overtime. Yet, it has a number of limitations why this may not be the right tool to determine well-being for an individual country.

Firstly, when using income per capita as measurement, the income distribution does not gauge precisely. Income per capita is an average. Hence, it neglects the income distribution within a country. Though the country’s GDP per capita may be very high, it may be the fact that 10 percent of the population of the country makes millions of times more than other 90 percent of the population of the country who makes little wages. It means outliers who are within the population of a country (extremely poor or rich) can have an uneven result on the overall outcome.

Secondly, by looking at the example in (a), we can see clearly that income per capita does not represent the real living standards of the whole population of the city as it is the average income of a population and the income does not allocate equally among all the population of the country.

Besides, income per capita neglects the consequences of inflation. Income per capita will be unnaturally overstated if the prices increase more rapidly in one country than in another.

In addition, the amount of money in different countries will have different values due to the varying exchange rates. Hence, comparing income per capita country to country gives inaccurate results. It may be more appropriate to measure when comparing different years in an individual country.

What’s more, just because a country’s income per capita is high doesn’t mean that country is high standards of living. It may be because of working longer hours, not because of earning high salaries. The more people work, the more stress and the more workload they get. Working long hour makes the people’s stress level high and it reduces the personal leisure time which decreases the standards of living and gives less happiness in their lives.

Furthermore, the values shown up at income per capita do not include the quality of the goods is another fact why GDP per capita may not be the right tool to measure the living standards of life. The output may probably be increased. However, the goods which are being produced are of poor quality, therefore the quality of living standards may still not be getting better.

Finally, real GDP does not take account of externalities which are third party costs that do have an effect on living standards of the population, for instance, congestion and pollution. These pose costs on third parties and represent real opportunity costs for them, reducing their effectiveness disposable income, and hence living standards. Congestion, pollution and other negative externalities have obviously harmful effects on wellbeing. The time spent ill, results less working days and it cuts output, and moreover, the time being sick is an opportunity cost to leisure time.

c) Factors that need to be included when using ‘income per capita’

When comparing income per capita between countries, we have to have a common base measure to compare income per capita in different countries to get more accurate result. To compare income per capita among countries, the input data which are gathered in the local currency has to be converted to the common base currency being used for the comparison, for example, US dollars.

The problem of money inflation, which is mentioned in question (b), can be overcome by the use of money deflator by using a price index and therefore, the real per capita income is being compared and a better result of relative standard of living is deduced.

In addition, income per capita doesn’t show how a country’s income is disturbed and it also neglects about environment, human freedom and the value of leisure. As a result, one must also take into account other factors providing, such as longevity and people’s health, the distribution of income, the quality of environment, access to education and many more to examine the real quality of life in different countries.

All of the above factors need to be considered when using income per capita to assess differences in well-being among countries to make sure that meaningful comparisons are accomplished.

d) Human Development Index

The Human development Index (HDI) is a standard means of measuring well-being. It is used to point out the impact of economic measures on quality of life.

To assess the different countries’ living standards based on the fall and rise of incomes within that country, for instance, income per capita, is not an accurate way of determining that country’s development. There are a number of more important factors which should be assessed to get the real standard quality of life, for example, how healthy people are, what their potential is as a human beings and how the environment in which they are living is. For the purpose of giving a more comprehensive measure of well-being in both social and economic variables among countries, the HDI has developed as an alternative way to measure other aspects of human developments. The basic concept of HDI is to assess the development of a country through people of a country being healthy, being educated and having good standards of living. The person whether having healthy lifestyle is measured by life expectancy. The life expectancy determines the normal lifetime of the people of a certain region. It is also an aspect for assessing the physical life quality of a certain region. Being educated is one of the features in measuring HDI which is assessed by adult literacy and enrollment in primary, middle and high school level. Having good standards of living is measured by purchasing power parity, PPP and income. HDI is not a complete measure of development of country’s well-being. It does not take in important indicators, for instance, respect for human rights, inequality and democracy. However, by using HDI, governments are able to assess country’s well-being against other countries in a better way instead of just focusing success on money statics and it gives a broadened view of the progress of human and the complex link between well-being and income.

Question 2

(a) Deflationary gap takes place when the equilibrium level of income is less than the full employment income.

Expansionary monetary policies should be carried out to overcome the deflationary gap of an economy. Normally, in this case, a central bank will raise the supply of money to solve the problem of deflationary gap by means of reserve requirements and/or providing lower interest rates. Expansionary monetary policy, in reserve, allows banks to hold only a small amount of the total assets. Therefore, cash withdrawal can be available immediately and banks keep only a small amount of the total assets and the rest is put in liquid assets in the forms mortgages and loans. By reducing the reserve requirements, the funds of loan available are increased and it makes the money supply rise. By giving lower interest rates it encourage people and firms to borrow money and investment will rise. As the money supply increases, people will consume more goods and services. As the expansion of business cycle gets underway, wealth gets higher and this will head to a multiplied increase in national income.

(b) Inflationary gap occurs when there is too much demand in the economy and it takes place when the equilibrium level of income goes over the full employment income.

The inflationary gap can be controlled by implementing the deflationary fiscal policy. It could be done by raising taxes in some form and/or by reducing government spending. Either of these will slow down the economy level of demand and will help to reach the equilibrium level of economic growth. Deflationary fiscal policy will probably increase the tax on expenditures which lead to increase prices and discourage people from spending too much, or it may increase the tax on income that will make people less money so that they can stop people from spending so much and this will have a multiplied effect on national income.

(c)

Question 3

a. (i) Marginal utility

Utility is a person’s total satisfaction that obtained from when a customer consumes a good or service. Marginal utility is an additional satisfaction which one person acquires from using one additional unit of a good or service. As marginal utility concept is used by economists to examine how much units of good or service a customer will purchase, it is an essential economic concept. If the use of goods and services of an extra unit maximizes the total utility, it is positive marginal utility. It is a negative marginal utility if the use of goods and services of an additional unit minimizes the total utility.

a. (ii) Demand curve for good Y

The following diagram illustrates a demand curve D of an individual normal good Y, where P means the price charged for each unit of normal good Y and Q refers to the quantity demanded. The point ‘a’ which intercept vertically of the demand curve demonstrates the highest price for each unit of good Y that a person is willing to pay.

a. (iii) According to the demand curve above, the individual is prepared to pay an amount of ‘a’ for the first unit of consumption of good Y. since the demand curve for a normal good slopes downwards, the individual is prepared to pay less and less for consumption: their marginal valuation of the good falls with consumption. Under certain assumptions this marginal valuation (the height of the demand curve) can be thought of as a measure of marginal utility. (Note: as Q increases, the individual’s marginal valuation falls and hence marginal utility falls – the principle of diminishing marginal utility.

b. (i) Price elasticity of demand

According to law of demand, a drop in price of goods increases the demand of goods. A measure of how much percentage of a good quantity demanded responds to changes of price of that good is price elasticity of demand. If the demand of a good responds considerably to changes in price, demand for a good is elastic. If the demand of a good responds only a bit to changes in the price, then demand for a good is inelastic.

In formula,

b. (ii)

Given:

% change in quantity demand of good Z= (200-100)/100 x100 = 100

% change in price of good Z= (5-10)/10 x 100 = -50

Therefore, price of elasticity of demand of good Z= 100/50 = -2

c. (i) The following diagram shows a linear demand curve and the associated marginal revenue curve for a monopolist. The quantity demanded Q which is on the horizontal axis and the price P, on the vertical axis shows a linear demand curve, D for a good. Given that demand is linear, marginal revenue, MR is also linear and has twice the slope: the horizontal intercept of the demand curve, a, is twice that of the marginal revenue curve, a/2.

c. (ii) the demand curve has unit elasticity nd = -1 at the point where marginal revenue is equal to zero. The inelastic and elastic regions of the demand curve are those points to the right and left of this point.

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